The Unrepentant Recalcitrant

Lessons for an accidental entrepreneur

Archive for the tag “Gambling”

Valuation and its Discontents

The cornerstone of investing and entrepreneurship and perhaps even of life, is valuation.

Thats not hyperbole.

Think about it. You are valuing and weighing all day long, every day.

Obviously you need to value stocks and bonds if you are to invest.

Its also evident you want to understand how much your business is worth if you have a startup.

But there is more.

Whats that house you want to buy worth?

How about the car you purchased last year?

Do you value your collectibles? Your art?

How do you do that?

Lets go into uncharted territory.

Do you value your relationships? Looking for a girlfriend?

What is she worth?

(Its only a little tongue in cheek. Later, someday I’ll explain why. For now, we will stick with inanimate objects!)

As I described in an earlier post, we are putting a value or worth on assets (remember assets?).

Value and worth, as I have said before need not necessarily be the same as the price of the asset.

If its less than the price of the asset, we have an investable opportunity. Otherwise we don’t.

Lets use the value of a company stock as an example.

What is it worth?

There are many ways to determine this but a few that are important to consider.

Lets talk about four of them.

1. Asset Valuation
2. Liquidation Value
3. Replacement (or Competing) Value
4. Discounted Cash Flow Valuation

Asset valuation:

One way to assess value is to add up the worth of all the things the company owns…its buildings, its inventory, its machines and its cash and calculate its total asset value.

Lets say, you are in the middle of a depression. Companies are selling cheap (ca 1929).

It was possible to pick up companies at the time for less than the sum of their parts.

Benjamin Graham, the father of value investing made his fortune this way.

Liquidation Value:

A second way, in the case of a company that is being broken down and sold for its parts (liquidation value) is the total value of its assets minus some discount to account for the fact that everything it owns may not bring market value since it will be sold at fire sale prices.

More on this another day.

Replacement Value or the Valuation to Compete:

A third way to calculate value is to see the business as competition to us, and ask the following question:

“What would I need to do to build up a business just like this one and compete with it?”

Now that would include the asset value mentioned above but also the resources that have been deployed to build the brand(s), market the product(s), establish the customer and wholesaler relationships and distribution channels (among other things).

There is some hand waving involved here of course but its easy to see that the value of these intangibles (and semi intangibles) will add to the raw asset value we have described above.

Discounted Cash Flow valuation:

Finally, we can determine value by asking this question?

“If I owned this asset, what amount of money would I earn from it over a set period of time?”

If you owned a stock, what is the total value of dividends you would receive for it over time?

If you owned a whole business, what profit would you be able to get out of it every year for the duration of your ownership?

For each of these questions, we can (theoretically) construct a model of “cash flows“, i.e. the flow of money into your pocket over time.

Add that cash up.

Remember, you don’t have the cash in your pocket today. Its going to take time to get it all.

Over that time, you will live without that spending power.

So, the raw total of that cash must be “discounted” over the period you will need to get it into your pocket.

This is, in a word the discounted cash flow model of earnings (DCF) that allows you to estimate the value of an investment.
The discounted cash flow model of valuation (DCF) is de facto the most important method to understand, when valuing an asset that brings earnings.

Its incorrect to value a business with sales any other way (except in the situations I noted above).

I will speak more about DCF in later posts as it comprises the “V” in the “P/V” formula I introduced in the previous post.

I will leave you with a few final thoughts.

1. You cannot fully value an asset without cash flows (or the future promise of cash flows).

2. If you cannot fully value an asset, you cannot be sure of the relationship of Price to Value (P/V).

3. If you cannot estimate P/V and ensure a margin of safety, you are unable to ascertain whether an asset is investable.

4. If you decide to purchase the asset anyway, you have not invested. Rather you have speculated or gambled. Be clear on this.

5. Ergo, any asset without cash flows is not likely to be an investment.

Let me repeat that last statement.

An asset without cash flows is not likely to be an investment.
(Ahh…the chaos that idea will create!)

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All Investing is value investing. The rest is speculation

Value Investing. Growth Investing. Momentum Investing. Trading. Real Estate. Precious Metals. Shorting.

A million different ways to lose your money (We should include failed startups to this now shouldn’t we? Heh Heh).

I am going to review some of the lessons I have learned about investing over several future posts but lets spend some time clarifying what we are talking about. Being exact is helpful in a situation where we are surrounded with many different voices in chaotic confusion.

An asset is something that puts money in your pocket either today or in the future. Today it might be cash in your pocket, and in the future it may be the result of an investment, a gamble or a speculation.

Value Investing (or Investing) is the act of acquiring an asset for less than what its worth. Once the asset reaches the point where it is valued at what it is worth (or more), we have made a profit. Agreed?

Speculation is the act of (well speculation, I guess!) an informed (yes, informed…maybe incorrect but informed) betting on the movement in the price of an asset or a presumed asset. If the speculation is correct, a profit is made, and if not, a loss is suffered.

Gambling is the act of largely (not uniquely, no) uninformed speculation that most often results in losses for the gambler and winnings for the counter-party. The counter-party may be a speculator or an investor.

Now lets be theoretical for just a second and invoke math (or maths, if you are British). The only guarantee of profit in the above scenarios comes from buying an asset for less than its worth, i.e. value investing. Its more complicated than that but lets start with the numbers.

When you speculate, you position a bet to take into account certain unperceived or less perceived visions of a future wherein the asset you purchase will sell for more than you paid for it, regardless of whether it is worth what you paid or what the next person pays you for it (Greater fool theory).

That last bit is important. Its important because it underlies the idea of “margin of safety”. The concept of margin of safety says that you have purchased an asset for so much less than it is worth, that even in the likelihood that the greater fool theory did not apply, you would either minimize your losses or make a profit when the asset is fully valued.

A value investor lives or dies by his margin of safety.

A speculator is less concerned by it.

A gambler does not even know it exists.

Every situation where you buy an asset for less than its worth is therefore an example of value investing (stocks in 2009, real estate in 2010, Europe for the longest time etc).

Every time you don’t do that but you believe something good will happen to you, (i.e. currency trading, buying and selling gold, real estate in 2007, European debt over the past few years etc), you are speculating. There is nothing wrong with it, but its good to know what you are doing very clearly isn’t it?

The difference then between these two methods of generating wealth is therefore predicated on whether there is a difference between the price of an asset and its intrinsic value. That in turn is predicated on the estimation of value, the most important item in our arsenal.

Let me be very clear on this so there is no doubt where I stand. If you are unable to ascertain the value of an asset, you are a speculator and if you don’t even know that there may be an intrinsic value that you are missing, you are a gambler and one that will lose to the house every single time.

Every single time.

You have no business investing/speculating/gambling if you are unable to ascertain value.

Am I clear?

Would you perform surgery on yourself without going to medical school?

Exactly. (sigh..I can see the gamblers in the audience going..Hmm.. Why not give it a try?)

If you insist on doing this without the fundamental knowledge of valuation, I have some news for you. You have a name on Wall Street.

Sucker. Muppet (if the counter party is Goldman Sachs).

Warren Buffet says and I paraphrase “Every game has a sucker. If you don’t know who that sucker is, its you. Sucker”

I know the wider world thinks buying and selling stocks and “playing” the market is easy. Dead Wrong.

The market makes its money off of you.

Ok, lets summarize what I said so far.

The least risk (or most sure way) to generate positive returns is by investing and specifically by buying an asset for less than it is worth.

Speculation done well is an art that is beautiful to behold. Some of the richest people in the world are successful speculators. However, its extraordinarily difficult to do and to do it consistently over time is a rare feat. When you see the best at their game, its sometimes difficult to tell whether they speculated or whether they are very savvy value investors.

Most speculators are lousy and should be reclassified as gamblers.

Its more risky and much more stressful.

I don’t need to say anymore about gambling, do I?

Whats next?

In future posts I will discuss the concepts of valuation, its pitfalls and what you must learn in order to perform a reasonably good valuation.

We will then go over the principles of value investing (There are only three principles, my wide eyed acolytes, so don’t worry!!).

Among these posts in the future, I will discuss why these principles can and should be generalized to entrepreneurship and perhaps even to the Right Thinking principles I have been discussing so far.

Flood me with your comments, but please only positive ones.

I have a fragile ego.

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